Morgan Stanley's No-Win Situation

May 10, 2005

By Emily Thornton Finally, Morgan Stanley Chairman and CEO Philip Purcell has detailed a blueprint for growth in an accelerated time frame -- but analysts still aren't buying it. On May 10, Purcell told a standing-room-only crowd of investors that his firm has the right team and strategy to rack up some of the highest returns on Wall Street. Flanked by two new co-presidents, he promised to deliver premium returns to shareholders ASAP: "The proof is in the doing, which is why we are focused on moving forward," Purcell declared.

But the reaction from the investment community could best be described as a collective yawn. Two analysts issued reports saying there was nothing new in the embattled CEO's presentation. Standard & Poors (like BusinessWeek Online, a division of The McGraw-Hill Companies) kept a hold recommendation on Morgan Stanley stock, citing statements by Purcell that the firm is operating in a more difficult environment and expects to see more employee departures. Morgan Stanley shares (MWD) fell 2.6% on the news, to close at $49.42 on May 10 -- a percentage-point decline within the range of other major Wall Street financial services firms, on average.

What will it take for investors to give Purcell a break? It's a tough question -- with inherent risks for the venerable bank. After listening to a dozen or so investors gripe about the shortcomings of Purcell's presentation, Punk Ziegel & Co. financial-services analyst Richard Bove found himself nonplussed. He thought Purcell had been more forthcoming than ever, and was dumbfounded by the fact that so many investors still seemed to be grousing. "This company is a jewel," Bove says. But "nobody is willing to give this guy a chance anymore. And if no one is going to give him a chance, the company is going to be sold."

MORE DETAILS, PLEASE. Bove's prediction is extreme. But rumors of a possible takeover have been flying around all spring. Moreover, Bove's concerns underscore the high-wire act that the embattled Purcell still must accomplish before stockholders vote on his stewardship at the investment bank's annual meeting next year.

Purcell has declared flat out that he will deliver one of the highest returns on equity on Wall Street -- no small feat in itself. He has acknowledged that the firm's ROE has been "middle of the pack" for the past two years, and that Morgan Stanley must take better advantage of trading opportunities. And he has pledged to whip the firm's retail-brokerage division into shape. Even so, some analysts still say they want more details.

There's an irony in all this. For all the calls for bolder action, it was in part because of a bold action on Purcell's part -- the announcement of a planned spin off the Discover unit -- that his presentation fell so flat. After pressuring Purcell to dump Discover, many analysts now think the move would do nothing to improve Morgan Stanley's bottom line.

DIFFERING OPINIONS. Bove begs to differ. With or without the spin-off, he believes Morgan Stanley's returns are bound to look better than its peers next year because the investment bank suffered from one-time trading losses and charges in 2004. Purcell pointed out to investors that Morgan Stanley suffered from $350 million in legal and aircraft-leasing related charges last year.

So the better the firm executes on Purcell's plan, the better the bottom line will look for Morgan Stanley, Bove argues: "If you compare Morgan Stanley's earnings with last year, you'll be comparing them with below trend numbers, so they'll have better than average increases on a percentage basis."

Others are far less sure. Some point out that Morgan Stanley's returns may deteriorate without Discover, which they surmise was one of Morgan Stanley's highest return businesses last year. (Morgan Stanley doesn't disclose Discover's ROE.) Without it, Morgan Stanley will look "a lot more like [other brokerage firms such as] Merrill Lynch in terms of its mix and its return on equity," says UBS financial services analyst Glenn Schorr. "You'll be left with a securities franchise with a 15% to 16% return on equity."

WATCHING THE CLOCK. If the spin-off goes through, it could also have an undesirable impact on the rest of the firm's businesses. Morgan Stanley's goal "is to once again lead the group in ROE, across the cycle," wrote Merrill Lynch financial-services analyst Guy Moszkowski after the presentation. "But Purcell seemed to indicate that the spin-off of Discover might delay this, noting that it had been a very profitable business and a major contributor of capital to the other business' expansion efforts."

True, when asked in the meeting to set a timetable for restoring Morgan Stanley to its top performing position, Purcell declined to give a hard-and-fast deadline. "We would like to show progress every year. We had a premium five out of the last seven years. And we would like to have a premium five out of the next seven," he replied

Still, it doesn't seem like many investors are willing to wait even a year for Purcell to fulfill his promise. This is a problem, since it usually takes 12 months or so for the results of any new initiative to trickle down to the bottom line -- and that's being optimistic.

"We all have to take a close look at how this company performs vs. the industry," says Anton Schutz, manager of the Burnham Financial Services Fund. Fairly or unfairly, many investors seem to want those premium Morgan Stanley returns yesterday. Thornton is an associate editor for BusinessWeek